Lousy Pay Raise? That May Be as Good as It Gets--Update

By Greg Ip Features Dow Jones Newswires

For anyone who collects a paycheck, there's some bad news, and some worse news.

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First, the bad: Unemployment may be at a 16-year low and the economic expansion may be third-longest on record, yet wage growth is miserable, clocking in between 2.5% and 3% for the past year. When unemployment was this low in the late 1990s and the mid-2000s, wages grew 4%.

Now, the worse: If a labor market this tight can't generate better pay, quite possibly it never will. In Japan and Germany, where unemployment is plumbing generation-lows, wages are moribund. This suggests the problem transcends borders: Minimal corporate pricing power, lackluster productivity growth and an aging workforce have all undercut employers' ability to pay better.

This threatens to throw a wrench into the Federal Reserve's plans. It is likely to raise interest rates at its meeting Wednesday and plans to keep doing so gradually over the next two years.

Yet its longstanding assumption that a fully employed economy would eventually nudge prices and wages higher looks shakier by the month. Consumer price inflation excluding food and energy slipped to 1.7% in May, the Labor Department reported Wednesday, a two-year low. The Fed targets a different index, which shows even lower "core" inflation."

For most of the last eight years, the Fed's assumption was a decent base case. Lousy pay was easily explained by a deep recession that left a glut of spare workers, many uncounted in the most common measure of unemployment, which robbed those with jobs of bargaining power. That explanation no longer washes. Broader measures of underemployment are close to their 2007 lows. Some 4% of jobs are vacant, matching the highest recorded since 2000. Anecdotes of worker shortages are too pervasive to ignore: Maine has released some prisoners early as tourism struggles to fill jobs, and in the western U.S., some farmers threw out crops for lack of workers to harvest them.

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Which raises the obvious question: If employers are so desperate for help, why not pay more? Because pay is closely tied to what employers can recover by raising prices (inflation) or sales per employee (productivity). Since 2012, U.S. businesses' selling prices have risen by 1.4% and worker productivity by 0.6% per year. At 2% the sum of those two figures, a proxy for sustainable wage growth, is the lowest in more than 60 years.

Worker pay has actually grown faster than that subdued 2% benchmark, because employers have absorbed the excess in their profit margins, which have fallen from record highs. As a result, labor's share of the total economic pie has been recovering and isn't far from its long-run average.

Raises may also be more prevalent than the subdued average pace of wage gains lets on. The Federal Reserve Bank of Atlanta looks at how much respondents to the monthly household employment survey say their pay has risen in the last year and finds the median raise has doubled since 2010 to 3.5%, meaning half of workers saw pay rise by more, half by less. Why the median is so much higher than the average is unclear but may reflect the changing composition of the workforce. Employers hold on to their best employees in recessions. As the expansion matures they hire less-skilled and experienced workers. Because they come on board at much lower pay levels than incumbents, these newly hired workers' raises don't move the average much.

The same phenomenon happened late in the last expansion. This time there's an added wrinkle: Baby boomers have retired in droves since 2008, and their replacements are typically less experienced and thus earn less.

This is good news for many workers at the bottom. The median raise for a low skilled worker has risen from 1% in 2013 to 3% now, and for a young worker (aged 16 to 24) from 3.5% to over 7%. But it spells trouble for the economy as a whole. As more low-skilled workers join the workforce, its average quality suffers, which is bad for productivity. Researchers at the Federal Reserve Bank of San Francisco and Bart Hobijn at Arizona State University predict that in the next few years, labor quality would continue to deteriorate assuming more of the newly hired come from the fringes.

That doesn't dictate worse productivity and pay, but it sure doesn't help.

For wage gains to grow sustainably faster, either prices, productivity or both have to grow much faster. But inflation is below the Fed's 2% target and has lately actually drifted lower. Even if it returned to 2%, higher real (i.e., after inflation) wages requires better productivity growth. It did edge above 1% in the last year, and with business investment picking up, that pace may be sustained.

Experience abroad, however, is not encouraging. In Japan, unemployment is the lowest in decades and labor shortages are rampant. Yet wage growth hovers around zero in part because retirees are taking menial jobs to supplement their pensions.

Germany has the tightest labor market in two decades, but pay gains are below 2%. Like the U.S., both countries are grappling with the interrelated problems of lackluster productivity and an aging labor force whose most-experienced and best-paid workers are retiring.

Inflation is subdued in both.

For now, the Fed remains confident unemployment this low will eventually get inflation back to 2%. Productivity growth is also long overdue for some sort of rebound. Yet for this to get wage growth back to 4% is a stretch, all the more so when an expansion is as long in the tooth as this one. In short, if you just got a raise, enjoy it: It might be as good as it gets.

Write to Greg Ip at greg.ip@wsj.com

(END) Dow Jones Newswires

June 14, 2017 10:44 ET (14:44 GMT)